Japan's never-ending dilemmas

Japan still cannot get its act together, a quarter of a century after the bursting of its bubble economy, writes John West.

Japan was Asia's original miracle economy. It rose dramatically from the ashes of military defeat in 1945. In the 1950s and 60s, Japan's annual economic growth rate was around 10%, the same as China in the first three decades of its reform period. In the 1970s and 80s, Japan's annual growth rate slipped down to the still-respectable 4%.

Already in 1964, less than two decades after the war, Tokyo hosted the Olympic Games, and showed off to the world its high-speed train from Tokyo to Osaka (the shinkansen). Today, more than half a century later, countries like the US, Canada and Australia can still only dream of having such impressive infrastructure.

Japan’s high growth, catch-up period was engineered by partnership between business, bureaucrats and politicians, the "iron triangle". Infant industries were protected from imports and inward foreign investment to give the export-oriented manufacturing sector the breathing space for industrial upgrading. (This model of development is often called the “developmental state”.)

Japanese companies conquered world markets, especially for motor vehicles and electronics. Companies like Toyota and Sony were the envy of the world, as were Japanese business practices like “kaizen” (continuous improvement), lean manufacturing, and just-in-time inventory management. By 1990, Japan’s GDP per capita had risen to 80% of the US level.

Japan's bubble economy

But in the late 1980s, a real estate and stock market bubble took hold, fuelled by easy money policies in response to a rising yen. The bubble was also driven by hubris and irrational exuberance. Many believed that Japan was becoming the leading global power, and that the US was set for decline. Japanese companies went on an international spending spree, as Mitsubishi bought the Rockefeller Center in Manhattan, and Sony bought Columbia Pictures. And during the height of the property bubble, Tokyo’s imperial palace grounds were believed by some to be worth more than all the real estate in California.

But then the bubble burst, and real estate and stock prices came crashing down again. Many banks, companies and citizens were thus saddled with large debts. The government responded sluggishly, in part due to disbelief. But the iron triangle also sought to protect enterprises and banks from the consequences of their follies.

Japan's tectonic shifts

The early 1990s proved to be a major turning point in Japan's history -- something which was not fully appreciated at the time. The tectonic plates underlying Japan were shifting. Strategic, systemic adaptation was required for many reasons.

Japan’s developmental state model resulted in lopsided development. While its manufacturing sector was a world leader, Japan’s services and agricultural sectors were highly inefficient. Even today, productivity in Japan’s services sector is only half that of the manufacturing sector. When it comes to services like finance, education and tourism, Singapore and Hong Kong are Asia’s leaders.

Japan desperately needed fresh competition from trade and investment liberalization and deregulation to stimulate productivity in these inefficient sectors. But the very success of the iron triangle, and the constellation of interests that coalesced around it, have made subsequent reform difficult, as Mark Beeson has argued. This includes corporate/government collusion through the parachuting of retired officials into high-level corporate positions, known as amakudari.

Another tectonic shift was the offshoring of much of Japan’s labour-intensive manufacturing to other Asian countries like China, Thailand, Singapore and Indonesia, in response to the higher value of the yen, and new opportunities in these countries. But while the manufacturing sector was being “hollowed out”, Japan remained closed to inward foreign direct investment, which even today remains at only 4% of GDP. This has robbed the economy of lots of opportunities to improve productivity and create decent, high-paying jobs.

Today, Japan is not a closed market for inward FDI, according to the OECD. And the current government has an ambitious target for doubling FDI. But there are very many “social practice” hurdles for foreign investors, especially constraints on labor mobility, an insular and consensual business culture less open to mergers and acquisitions, a lack of independent directors on many company boards, and cultural and linguistic barriers.

The corporate landscape of East Asia has also changed radically. Japanese companies were once undisputed leaders in Asia, but they gradually began to struggle in the face of stiff regional competition. For example, Korea’s Samsung and Taiwan’s contract manufacturer Foxconn have become leaders in mobile technology, while China’s Huawei and Xiaomi occupy a large slice of the low end of the market. Fortunately, Japan has developed a niche in high-tech components for mobile phones.

In the automobile field, Hyundai has become a challenger for Toyota, while Chinese automobile industry is now the world’s largest and is developing rapidly. Strangely, Japan does not seem to be a major player in the rapidly emerging driverless car sector. And Japanese banks are no longer globally powerful. True, Japanese companies like Softbank, Uniqlo, Muji, and Rakuten are making their mark. But Japanese companies no longer dominate, as they once did.

Another shifting tectonic plate has been Japan's unfolding demographic drama. Japan’s fertility rate has been below the replacement rate of 2.1 children per woman since 1975. Thus, Japan’s long awaited decline in its work force began in 1995, while its population began its inevitable decline around 2010. This has a direct hit on the potential GDP growth rate. Indeed, the Bank of Japan estimates that the economy is now only capable of growing at 0.5% a year over the medium term. And needless to say, Japan’s ageing population is also giving a big hit to the government’s budget deficit. And while Japan's demographic drama has been looming for decades, the government's response in terms facilitating greater economic participation by women and admitting more migrants has been woefully inadequate. To this day, Japan remains sadly xenophobic and sexist.

Japan's education system also desperately needs reinvention. It was very effective at promoting the literacy and numeracy of its population, things that were certainly very important when Japan was catching up to world leaders. But Japan's education system still emphasizes rote learning, memorization and passing tests, rather than critical thinking and creativity -- at a time when Japan needs to become more innovation-driven.

And while globalization has been the dominant feature of the past few decades, the Japanese are very poor at the world's global language, English. According to one survey, Japan’s English-language proficiency is only “average”, and behind Asian neighbours like Singapore, Malaysia, India, Korea and Vietnam, and only on par with Taiwan and Indonesia. This has many consequences from making Japan a difficult country to visit for tourists to isolating Japanese scholars from global networks.

Japanese Nobel Prize winning scientist Susumu Tonegawa had some insightful comments on Japan's education: "Having spent a half century abroad since I went to the United States to study, I now regard Japan as a society rather dictated by rules. Within a fixed framework, the Japanese are able to produce things with extreme precision ... A climate that respects individualistic thinking -- thinking not bound by conventional wisdom -- will produce revolutionary discoveries that shatter the framework. Unlike the Japanese, Americans put their own ideas first, and what others think of them is secondary. It is essential to have education that respects individual abilities and preferences."

Japan's lost decades

These tectonic shifts have haunted Japan for over two and a half decades. Economic growth has been very sluggish, averaging only about 1% a year. Reforms have been proposed and discussed, but their implementation has never been serious. Japan’s economy and society have been dragged down as a consequence.

Japan’s GDP per capita, at $32,322 in 2015, has fallen back to only 58% of that of the US. The country’s once egalitarian society is now fracturing, as the share of people living in relative poverty has leapt from 12% in 1985 to 16%, putting it just behind the US, with the second highest poverty of the advanced OECD countries, while income inequality is also above the OECD average. When it comes to child poverty, Japan now has a higher rate than the US, and 50% of single parent households live in poverty.

Many visitors to Japan are shocked to hear of stories of Japanese poverty, because you don’t see any beggars and street crime is virtually non-existent. But much poverty is hidden, as it can be a subject of public shame and discrimination. And many urban homeless live in tents in public parks or on river banks.

Japan’s public debt has reached world record levels at 240% of GDP, as the government spending has been continuously used to keep the economy afloat. This has kept the government’s friends in the construction industry happy, but also led to much wasteful spending and white elephants. Social spending on Japan’s rapidly ageing population has been the other factor driving debt.

As desperate as the public debt situation might seem, the government has no meaningful plan to bring it under control. The OECD has projected that it could well skyrocket to over 400% of GDP by the year 2040. But before that date, markets will surely lose confidence in Japan, leading to a surge in capital flight and a crash in the yen. Japan has also suffered from deflation for much of the past two decades. Such falling prices weakens the economy, but it also exacerbates the debt problem, as the value of debt does not change, while the value of incomes and GDP are falling.

Japan's stagnation trap

In short, Japan is caught in a "stagnation trap". But it’s not late for Japan to get its act together. After all, in recent history it has performed two miracles -- one following the Meiji Restoration and the other following World War 2. But “Abenomics”, the programme of economic revitalisation of the current government led by Prime Minister Shinzo Abe, is a case of too-little, too-late. Its structural reform “arrow” component, the most important of all three, is still sitting in the quiver. But it is difficult to see anything other than a real open crisis, rather than a slow burner, moving this cautious and conservative country into action.